Contributed by Damon P. Meyer
It is well-settled law that corporate governance rules continue to apply during a chapter 11 case, unless a chapter 11 trustee has been appointed. With respect to a public company, the debtor’s board of directors continues to manage the affairs of the company, and the debtor’s shareholders continue to be able to exert their power by, among other things, conducting shareholder meetings and replacing directors. At the same time, however, during a chapter 11 case, the board must consider the interests of all creditor constituencies, and therefore, equity’s power to direct the board must not be absolute.
Today’s edition of Throwback Thursday looks back to the Second Circuit Court of Appeal’s 1986 decision in In re Johns-Manville Corp., which addressed the interplay between the potentially conflicting goals of equitable distribution and respect for corporate governance. In this case, the Second Circuit reiterated the rule that shareholders’ right to call a meeting and elect new directors may only be impaired if, in doing so, the shareholders are “guilty of clear abuse.”
The Manville case was extraordinarily contentious, and at the time of this decision, the case had been pending for nearly four years. Parties in interest included not only present creditors and equity holders, but also future tort claimants (represented by an appointed legal representative), and each of these parties formed various official committees and ad hoc alliances to assert their interests. Nonetheless, the Manville board of directors continued to have the exclusive right to file, and seek solicitation on, proposed chapter 11 plans. (At the time of this decision, exclusivity could be continuously extended. The Bankruptcy Code has been amended since the time of this decision, however, to provide for limited extensions to exclusivity.)
After years of negotiating and the filing of numerous proposed chapter 11 plans, in August 1985, the board filed a proposed plan that was largely consensual among Manville’s creditors. The plan, however, diluted existing equity by approximately 90%, which equity holders viewed as “an abdication of [the board’s] responsibilities to the shareholders.” As a result, equity holders brought an action in Delaware state court seeking to compel Manville to hold a shareholder meeting with the stated purpose of replacing Manville’s board of directors. In response, the Manville debtors filed an action in the bankruptcy court to enjoin the Delaware action and prevent any newly elected board member from taking office without bankruptcy court approval. Both the bankruptcy court and the district court granted summary judgment to Manville and held that the actions of the equity holders constituted clear abuse.
The Second Circuit, however, found there to be triable issues of fact and remanded the case to the bankruptcy court. In doing so, the Second Circuit examined the “clear abuse” standard and set forth the parameters for what constitutes “clear abuse.” Specifically, the Second Circuit held that “the shareholders’ mere intention to exercise bargaining power – whether by actually replacing the directors or by ‘bargaining away’ their chip … cannot without more constitute clear abuse.” The Second Circuit also noted that to constitute clear abuse, the shareholders must be bargaining in bad faith, by demonstrating a “willingness to risk rehabilitation altogether in order to win a larger share for equity.” Moreover, the Second Circuit held that shareholders were not guilty of clear abuse where rehabilitation was merely delayed – it must have been seriously threatened.
On remand, the bankruptcy court held that the shareholders’ actions constituted clear abuse. The main basis for the bankruptcy court’s finding was that the debtors and other parties in interest had negotiated with the equity holders throughout the chapter 11 case; however when a plan was proposed that diluted equity, the shareholders ceased cooperation. Instead, the shareholders refused to negotiate and, eventually, commenced the Delaware action. Furthermore, the bankruptcy court noted the “fragile nature” of the support for the proposed plan and that the consequences of failure to confirm the plan could be disastrous to the prospects of reorganization.
Although it is easy to remember that corporate governance rules apply in chapter 11, it is equally easy to forget the extent to which this is true. A look back at Manville can remind us all that shareholders continue to control a company during its restructuring, and, absent “clear abuse” can replace directors during the case.